Course Outline and Session Plan

Readings and Book

Session(s) Topics to be covered
Chapter(s)
PR: chapter 1
1 Managerial economics: an introduction
PL: chapter 1
2-4 Demand, supply, price and elasticity PR: chapter 2

MANAGERIAL 5-7 Theory of consumer behavior PR: chapters 3 & 4

ECONOMICS 8-9 Production and cost analysis

Market structures and price output
PR: chapters 6 & 7

PR: chapters 8 to 11
10-12 determination – perfect competition and
PL: chapter 9
monopoly
Market structures and price output
- 13-15 determination – monopolistic competition and
PR: chapter 12
PL: chapter 10
oligopoly
Prof. Sanjay K. Singh PR: chapter 13
16 Game theory and strategic behavior
Indian Institute of Management Lucknow PL: chapter 11

17 Externalities and public goods PR: chapter 18

18 Economics of information asymmetry PR: chapter 17

PR: chapter 5
19 Decision making under uncertainty
PL: chapter 14
From website –
20 Competition policy and economic regulation
www.cci.gov.in

READINGS Evaluation (PGP)

 Textbooks:
The course will be graded on the following
Microeconomics by Robert S. Pindyck and Daniel components:
L. Rubinfeld, Pearson, Eighth Edition.
Managerial Economics by H. C. Petersen, W.C. Assignments and Quizzes: 30%
Lewis, and S.K. Jain, Pearson, Fourth Edition
 Reference Book: Course Commitment: 10%
Microeconomics: Theory and Applications by D.
Salvatore, Oxford University Press, Fourth Mid-term Examination: 25%
edition.
End-term Examination: 35%
 Polycopy containing few useful articles
 Economics is the study of the allocation
of scarce resources.
MANAGERIAL
ECONOMICS: SCARCITY . . .
AN INTRODUCTION
. . . means that society has limited resources and therefore
cannot produce all the goods and services people wish to
have.

TEN PRINCIPLES OF ECONOMICS

ECONOMISTS STUDY. . .
How People Make Decisions?

How people make decisions? 1. People face tradeoffs.

How people interact with each other?
The forces and trends that affect the
economy as a whole.
 Having more of one good means having less of another
 Society faces tradeoffs in efficiency versus equity
 You face tradeoffs in how best to allocate your time; the
choice to attend B-School rather than being in labor
force
2. People face opportunity cost (cost of something is
what you give up to get it).
What is the opportunity cost of your IIM education?
What is the opportunity cost of attending this lecture?
Undertake an activity if the benefit  its opportunity cost
TEN PRINCIPLES OF ECONOMICS
How People Make Decisions?
3. Rational people think at the margin (The Marginal
Principle) i.e., the relevant benefits and costs to
consider are marginal.
Marginal cost is the additional cost of one unit
increase in an activity (MC)
Marginal benefit is the extra benefit resulting from
one unit increase in an activity (MB)
If the marginal benefit of an activity exceeds its
marginal cost, do it
If the marginal benefit of an activity is less than its
marginal cost, don’t do it
Keep doing the activity until the marginal benefit
just equals the marginal cost
TEN PRINCIPLES OF ECONOMICS
How People Interact
5. Trade can make everyone better off.
 Produce and export a good in which you have a comparative
advantage (if the opportunity cost of producing that good is lower
in the country than it is in other countries).
 Even if a country is having absolute advantage (or disadvantage) –
the most (or least) efficient producer of all goods, it still can
benefit from trade.
The benefits of trade do not depend on absolute advantage, rather
they depend on comparative advantage: specializing in industries
that use resources most efficiently.
The competitive advantage of an industry depends not only on its
productivity relative to foreign industry, but also on the domestic
wage rate relative to the foreign wage rate.
Therefore, an absolute productivity advantage is neither a
necessary nor a sufficient condition for having a comparative
advantage.
TEN PRINCIPLES OF ECONOMICS
How People Make Decisions?
4. People respond to incentives.
People’s behavior may change if costs/benefits change
As petrol / diesel prices rise, people drive less, walk
more, use public transportation more often; purchase
fuel-efficient cars, …
But, sometime, government policy may have
unforeseen consequences
Do seat belts reduce auto deaths/improve auto safety?
Seat belt laws encourage drivers to drive faster, since
risk of death gets reduced (cost of poor driving falls).
There is a higher risk of accidents, but lower risk of
death if you’re in an accident and wearing your seat
belt. Although driver fatality may be reduced due to
seat belt laws, pedestrian fatality is likely to increase.
TEN PRINCIPLES OF ECONOMICS
How People Interact
6. Markets are usually a good way to organize economic
activity.
7. Governments can sometimes improve economic outcomes.
How the Economy as a Whole Works
8. The standard of living depends on a country’s production.
9. Prices rise when the government prints too much money.
10. Society faces a short-run tradeoff between inflation and
unemployment.
MACROECONOMICS VERSUS MICROECONOMICS
WORLD AND PREDICT BEHAVIOR
 Macroeconomics looks at the economy as a
whole and focuses on economic aggregates:
Total economic output, employment
Inflation, unemployment
Trade deficit; budget surplus/deficit
Economic growth and business cycles
Monetary policy, fiscal policy
…  Sports
 Microeconomics focuses on the individual parts of the
economy and studies individual decision makers and
their interaction in the market
 Households, firms, industries, government, …
WHAT IS MANAGERIAL ECONOMICS?
Applied micro-economics, but with a focus on
decision making
“What shall a manager do in this and that
situation?”
Pricing decisions in different circumstances
Market entry, advertising, innovation, …
Organization of the firm
Personnel policy, how to motivate workers …
MICROECONOMICS HELPS YOU UNDERSTAND THE
 Why do monopolistic firms earn higher profits than
more competitive firms?
 Why are airline tickets cheaper in lean season?
 Can government regulation improve market
outcome?
Microeconomics is one way of looking at the world
 Thus, there is an economics of:
 Health care
 Housing and urban policy
 Education
 International Trade
 Energy
 Transport
 Deregulation
POSITIVE VERSUS NORMATIVE ANALYSIS
 Positive statements are statements that describe the
world as it is.
 Called descriptive analysis.
 E.g., impact of raising gasoline tax on price of gasoline, car-km,
demand of cars, costs on consumers, effects on profit and
employment in the oil, automobile, and tourist industries, and
the amount of tax collected by the govt.
 Therefore, positive statements describe relationship of cause
and effect.
 Normative statements are statements about how the
world should be (What is best?).
 Called prescriptive analysis.
E.g., once high tax on gasoline is in place, what is the best mix of

large and small cars for automobile companies; how much
investment should be made to make fuel efficient cars? For
policy makers, is increase in tax good for society? What is the
optimal tax rate?
 WHAT IS A MARKET?
A market is a group of buyers and sellers of a
particular good or service.
THE MARKET FORCES OF  Market includes more than an industry; an industry is
a collection of firms that sell same or similar products.
SUPPLY AND DEMAND
 Therefore, an industry is only supply side of the
market.
DEMAND, SUPPLY, PRICE  The terms supply and demand refer to the behavior of
AND ELASTICITY people . . . as they interact with one another in market.
 And economics, especially microeconomics is about
how supply and demand interact in markets.

Market Definition - The Extent of a Market MARKET FOR SWEETENERS

Boundaries of a market, both geographical and in terms of In 1990, the Archer-Daniels-Midland Company (ADM) acquired
range of products produced and sold within it. the Clinton Corn Processing Company (CCP).
Market definition is important …A company must ADM was a big company that produced various agricultural
understand who its actual and potential competitors are for the products including high fructose corn syrup (HFCS). CCP was another
various products that it sells or might sell in the major US corn syrup producer. (together they produced 70% of US corn
future…Market definition may be important for public policy syrup).
as well... The U.S. Department of Justice (DOJ) challenged the acquisition
MARKETS FOR BICYCLES Two different on the grounds that it would lead to a dominant producer of corn
TYPE OF BICYCLE COMPANIES AND PRICES markets for bicycles syrup with the power to push prices above competitive levels.
(2011)
Mass Market Bicycles: Huffy: $90—$140
ADM fought the DOJ decision, and the case went to court. The
Sold by mass merchandisers Schwinn: $140—$240 basic issue was whether corn syrup represented a distinct market.
such as Target, Wal-Mart,
Kmart, and Sears.
Mantis: $129—$140
Mongoose: $120—$280
ADM argued that sugar and corn syrup should be considered
part of the same market because they are used interchangeably
Dealer Bicycles: Sold by Trek: $400—$2500
bicycle dealers – stores that Cannondale: $500—$2000 to sweeten a vast array of food products (e.g., soft drinks).
sell only (or mostly) bicycles Giant: $500—$2500
and bicycle equipment. Gary Fisher: $600—$2000 In October 1990, a federal judge agreed with ADM’s argument
Mongoose: $700—$2000
Ridley: $1300—$2500 that sugar and corn syrup were both part of a broader market for
Scott: $1000—$3000 sweeteners. The acquisition was allowed to go through.
Ibis: $2000 and up
 REAL VERSUS NOMINAL PRICES
MARKET TYPES OR STRUCTURES ● Nominal price - Absolute price of a good, unadjusted for
inflation (price at current prices). E.g., milk price was Rs. 15/l in
 Competitive Markets 1990, Rs. 25/l in 2000, and Rs. 50/l in 2018.
Homogeneous product, large number of buyers and ● Real price - Price of a good relative to an aggregate measure of
sellers, no player has any control on prices, no prices (CPI/WPI/PPI); price adjusted for inflation (price at constant
entry/exit barrier, … prices). Real price can be used to have meaningful comparison
of prices across time.
 Monopoly ● Consumer Price Index - how much retail prices change for
 Monopolistic Competition consumer goods and services? (products purchased by consumers)
 Oligopoly
● Wholesale Price Index - how much prices change for goods
traded between corporations in the wholesale market?
● Producer Price Index - how much prices of raw materials
At what prices goods are traded depend heavily on and other intermediate products bought by firms, as well as finished
market structure… prices I mean real prices… products sold at wholesale to retail stores change? (products normally
purchased by businesses)
PPI/CPI includes services, WPI doesn’t; PPI doesn’t include indirect taxes; WPI (2011-12) tries to
Do you know the difference between real and mimic PPI by not including indirect taxes. CPI (combined) is declared as the new standard for
measuring inflation in India (April 2014).
nominal prices? Which price index to use to covert nominal prices to real prices?
It depends on the type of product we’re examining (butter: CPI; Coal: WPI).

THE PRICE OF EGGS AND THE PRICE OF A THE REAL AND NOMINAL MINIMUM WAGE IN
COLLEGE EDUCATION IN THE US THE US (was first instituted in 1938 @ 25 cents/hour)
THE PRICES OF EGGS AND OF A COLLEGE EDUCATION
1970 1980 1990 2000 2010
Consumer Price Index 38.8 82.4 130.7 172.2 218.1
Nominal Prices
Grade A Large Eggs $0.61 $0.84 $1.01 $0.91 $1.54
College Education $2,112 $3,502 $7,619 $12,976 $21,550
Real Prices ($1970)
Grade A Large Eggs $0.61 $0.40 $0.30 $0.21 $0.27
College Education $2,112 $1,649 $2,262 $2,924 $3,835

CPI (1983) = 100

The real price of eggs in 1970 dollars is calculated as follows:

THE MINIMUM WAGE

In nominal terms, the federal minimum wage has increased steadily
While the nominal price of eggs rose during these years, the real price of eggs
over the past 70 years. However, in real terms its 2010 level was below
actually fell. Proportionate change in real price would be same for any base
that of the 1970s.
year (1970 or 1980 or …).
 Let us now see how supply and demand curves
are used to describe the market mechanism. WHY DOES THE DEMAND CURVE SLOPE
DOWNWARD?
Price of Ice-
Cream Cone
INDIVIDUAL DEMAND CURVE
 Law of Demand
$3.00 Ceteris paribus (e.g., when income is unchanged), there is
an inverse relationship between price and quantity
2.50 demanded.
Ceteris paribus is a Latin phrase that means all variables
2.00 relationship between price and demand other than the ones being studied are assumed to be
constant. Literally, ceteris paribus means “other things
1.50 being equal.”

1.00  Law of Diminishing Marginal Utility

Utility is the satisfaction that one receives from
0.50 consuming a product.
Marginal means extra.
Quantity of Diminishing means decreasing.
0 1 2 3 4 5 6 7 8 9 10 11 12 Ice-Cream
Cones

TWO SIMPLE RULES FOR MOVEMENTS VS. SHIFTS

MARKET DEMAND
 Market demand refers to the sum of all
individual demands for a particular good or
service.
 Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
 So, market demand curve is the horizontal sum of
the demand curves of all consumers in the market.
 Rule One
When an independent variable changes and that
variable does not appear on the graph, the curve
on the graph will shift.
 Rule Two
When an independent variable does appear on the
graph, the curve on the graph will not shift,
instead a movement along the existing curve will
occur.
We may use the phrase change in demand/supply to refer
to shift in the curve whereas change in the quantity
demanded/supplied to apply to movement along the curve.
 Let’s apply these rules to the following cases of
supply and demand!
 MOVEMENT ALONG THE CURVE Shift in the Demand Curve
Price of
A movement occurs when a change in
Price of Ice- CONSUMER INCOME
Cigarettes Cream Cone
per Pack the quantity demanded is caused only by NORMAL GOOD
a change in its price, and vice versa. $3.00 An increase in income...
A shift in the demand curve
C 2.50
$4.00 occurs when a good's quantity
Increase demanded changes even though
2.00 in demand price remains the same.

1.50

2.00 A 1.00

D1
0.50
D2
D1
0 12 20 Quantity of Ice-
Number of Cigarettes 0 1 2 3 4 5 6 7 8 9 10 11 12
Cream Cones
Smoked per Day

PRICES OF RELATED GOODS

Shift in the Demand Curve SUBSTITUTES & COMPLEMENTS
Price of Ice-  When a fall in the price of one good reduces the demand
Cream Cone
for another good, the two goods are called substitutes.
CONSUMER INCOME
$3.00 INFERIOR GOOD  E.g., Copper and Aluminum; Chicken and Mutton; etc.
2.50 An increase  When a fall in the price of one good increases the
in income... demand for another good, the two goods are called
2.00 complements.
Decrease
1.50  E.g., Automobile and Gasoline; PC and computer software;
in demand
etc.
1.00
 When a fall in the price of one good doesn’t change the
0.50
demand for another good, the two goods are called
independent.
D2 D1  E.g., Toothbrush and Motorcycle; Shirt and LPG; etc.
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-
Cream Cones
 VARIABLES THAT AFFECT QUANTITY
DEMANDED SUPPLY CURVE
Price of
Ice-Cream
Cone
Variables that A Change in $3.00
affect Quantity this Variable . . . The supply curve slopes
Demanded 2.50 upward, demonstrating that
Price Represents a movement at higher prices firms
along the demand curve 2.00 will increase output
Income Shifts the demand curve
1.50
Prices of related Shifts the demand curve
goods 1.00
Tastes Shifts the demand curve
0.50
Expectations Shifts the demand curve

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-
Cream Cones

MARKET SUPPLY MOVEMENT ALONG THE SUPPLY CURVE

Price of
 Market supply refers to the sum of all individual
supplies for all sellers of a particular good or service.
Ice-Cream
Cone
S
 Graphically,individual supply curves are summed C
horizontally to obtain the market supply curve. $3.00 A rise in the price of
ice cream cones
results in a
movement along
the supply curve of
A ice cream cones.
1.00

0 1 5 Quantity of Ice-
Cream Cones
 SHIFT IN THE SUPPLY CURVE VARIABLES THAT AFFECT QUANTITY SUPPLIED
Price of S3
Ice-Cream
Cone
S1 S2 Variables that
Affect Quantity Supplied A Change in This Variable . . .

Decrease in Price Represents a movement along

Supply the supply curve
Input prices Shifts the supply curve
Increase in
Supply
A shift in the supply
Technology Shifts the supply curve
curve occurs when a Expectations Shifts the supply curve
good's quantity
supplied changes
even though price
remains the same.
0 Quantity of Ice-
Cream Cones

EQUILIBRIUM OF
THE MARKET MECHANISM
Price of
SUPPLY AND DEMAND
 The market mechanism is the tendency in a free Ice-Cream
market for price to change until the market clears Cone
Supply

 Markets clear when quantity demanded equals $3.00

quantity supplied at the prevailing price Equilibrium
2.50
 Market clearing price – price at which markets clear The curves intersect at
2.00 equilibrium, or market-
clearing price.
Quantity demanded
1.50
equals quantity
supplied at P=$2.
1.00

0.50 Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-
Cream Cones
 EXCESS SUPPLY EXCESS DEMAND
Price of
Ice-Cream When price is lower than
Price of market clearing price, say,
Cone Ice-Cream
Supply P = $1.50 (< $ 2.0).
Surplus Cone
$3.00 Unsustainable in free market.
Supply
2.50 When price is higher
than market clearing
price, say, $2.00
2.00 P = $2.50 (> $ 2.0).
Unsustainable in free $1.50
1.50 market.
Shortage Demand
1.00

0.50 Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice- 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of

Cream Cones Ice-Cream Cones

THREE STEPS TO ANALYZING HOW AN INCREASE IN DEMAND

CHANGES IN EQUILIBRIUM AFFECTS THE EQUILIBRIUM
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone
 Decide whether the event shifts the supply or
demand curve (or both).
 Decide whether the curve(s) shift(s) to the left or to Supply
the right.
$2.50 New equilibrium
 Examine how the shift affects equilibrium price
2.00
and quantity.
2. ...resulting Initial
in a higher equilibrium
price...
D2

D1
0 7 10 Quantity of
3. ...and a higher Ice-Cream Cones
quantity sold.
 HOW A DECREASE IN SUPPLY AFFECTS HOW AN INCREASE IN BOTH DEMAND AND
THE EQUILIBRIUM SUPPLY AFFECTS THE EQUILIBRIUM?
Price of
Ice-Cream 1. An earthquake reduces D
 Income increases P D’ S S’
Cone the supply of ice cream...
S2
S1 and raw material
prices fall
New Quantity increases P2
$2.50 equilibrium
If the increase in D P1
2.00 Initial equilibrium is greater than the
2. ...resulting increase in S price
in a higher
price... also increases
Demand

0 1 2 3 4 7 8 9 10 11 12 13 Quantity of Q1 Q2 Q
3. ...and a lower Ice-Cream Cones
quantity sold.

THE PRICE OF EGGS AND THE PRICE OF A COLLEGE

WHAT DETERMINES THE EQUILIBRIUM EDUCATION IN THE US
From 1970 to 2010, the real (constant-dollar)
OUTCOME WHEN THERE IS A SHIFT IN price of eggs fell by 55 percent, while the real
BOTH DEMAND AND SUPPLY CURVES? price of a college education rose by 82 percent.

The mechanization of poultry farms sharply

The relative size and direction of the change and reduced the cost of producing eggs, shifting the
The shape of the supply and demand curves supply curve downward. The demand curve for
eggs shifted to the left as a more health-
conscious population tended to avoid eggs.

As for college, increases in the costs of equipping and

maintaining modern classrooms, laboratories, and libraries,
along with increases in faculty salaries, pushed the supply curve
up. The demand curve shifted to the right as a larger percentage
of a growing number of high school graduates decided that a
college education was essential.
THE PRICE OF EGGS AND THE PRICE OF A
COLLEGE EDUCATION IN THE US
(a) MARKET FOR EGGS
(a) The supply curve for eggs shifted
downward as production costs fell; the
demand curve shifted to the left as
consumer preferences changed. As a
result, the real price of eggs fell sharply
and egg consumption rose.
ANOTHER EXAMPLE: THE PRICE OF COPPER
(b) MARKET FOR COLLEGE EDUCATION
(b) The supply curve for a college education
shifted up as the costs of equipment, maintenance,
and staffing rose. The demand curve shifted to the
right as a growing number of high school graduates
desired a college education. As a result, both price
and enrollments rose sharply.
Consumption of copper has increased about a
hundredfold from 1880 through 2000s
The long term real price for copper has remained
relatively constant
Increased demand as world economy grew
Decreased production costs increased supply
Why production costs fell?
Mainly due, first, to the discovery of new and bigger
deposits that were cheaper to mine, and then to technical
progress and the economic advantage of mining and
refining on a large scale.
Over the long term, increases in supply were greater than
increases in demand; consequently prices often fell.

Long-Run Movements of Supply and Demand

Consumption and Price of Copper for Mineral Resources

Although demand for

Although annual most resources has
consumption of increased
copper has dramatically over the
increased about a past century, prices
hundredfold, have fallen or risen
only slightly in real
the real (inflation-adjusted)
(inflation- terms because cost
adjusted) price reductions have
has not changed shifted the supply
much. curve to the right just
as dramatically.

In fact, during the past century, prices of most other natural

resources have also declined or remained roughly constant
relative to overall prices.
 QUESTION ANSWER
WHAT HAVE YOU LEARNED SO FAR WHAT HAVE YOU LEARNED SO FAR

 Each of the events listed below has an impact on the  A. supply, shifts left, equilibrium price rises,
market for bicycles. For each event, which curve is equilibrium quantity falls
affected (supply or demand for bicycles), what direction
is it shifted, and what is the resulting impact on  B. demand, shifts right, equilibrium price and quantity
equilibrium price and quantity of bicycles? rise
 A. The price of steel used to make bicycle frames
increases.  C. demand, shifts left, equilibrium price and quantity
 B. An environmental movement shifts tastes toward
fall
bicycling.  D. supply, shifts right, equilibrium price falls,
 C. Consumers expect the price of bicycles to fall in the equilibrium quantity rises
future.
 E. demand, shifts right, equilibrium price and quantity
 D. A technological advance in the manufacture of
bicycles occurs. rise
 E. Consumers' incomes decrease, if bicycles are an
inferior good

ELASTICITY . . .
… is percentage change in one variable with respect to
percentage change in another variable.
ELASTICITY AND ITS That’s why, it measures the sensitivity of one variable to
another.
APPLICATION
 Economists want to compare apples and oranges all the
time.
Is oil market demand more price sensitive than wheat
demand? (no)
Is the labor supply of women more wage sensitive than
the labor supply of men? (yes)

Elasticities allow economists to quantify the differences

among markets without standardizing the units of
measurement (it does not matter how we measure the
price or the quantity in different markets).

PRICE ELASTICITY OF DEMAND
 Price elasticity of demand is the percentage change in
quantity demanded given a percent change in the
price.
P = the current price of a good
Q = the quantity demanded at that price
P = small change in the current price
Q = small change in the quantity demanded
Price Elasticity of Demand = (Percentage Change in
Quantity) / (Percentage Change in Price)
Price Elasticity of Demand = ((Q/Q)/(P/P)) =
dlnQ/dlnP (from the calculus).
COMPUTING THE PRICE ELASTICITY OF
DEMAND USING THE MIDPOINT FORMULA
Although the exact formula for calculating an elasticity
is useful for theory, in practice economists usually
calculate an approximation called the symmetric
midpoint formula elasticity.
This is also called arc elasticity (is the elasticity of one
variable with respect to another between two given points).
Formula used for this is a bit different from that of point
elasticity.
(Q2  Q1 )/[(Q2  Q1 )/2]
Price Elasticity of Demand =
(P2  P1 )/[(P2  P1 )/2]
COMPUTING THE PRICE ELASTICITY OF DEMAND
Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones then your elasticity of demand would be calculated as:
(8  10)
10
100
 20 percent
  2
(2.20  2.00)
100 10 percent
2.00
What if this question is changed a bit?
If the price … decreases from $2.20 to $2 and the amount
you buy increases from 8 to 10 cones, then?
-2.75
Point elasticity of demand varies depending on where it is
measured along the demand curve.
We can resolve this problem by using the arc elasticity of
demand (elasticity over a range of prices or elasticity over
some portion of the demand curve).
COMPUTING THE PRICE ELASTICITY OF DEMAND
Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones the your elasticity of demand, using the midpoint
formula, would be calculated as:
(8  10)
(10  8) / 2  22 percent
(2.20  2.00)

9.5 percent
 2.32
(2.00  2.20) / 2
Arc elasticity value is different from point elasticity value because
point elasticity is for an infinitesimally small change in price and
quantity. The point elasticity can be approximated by calculating
the arc elasticity for a very short arc, e.g., 0.01% change in price.
Arc elasticity will always lie somewhere (but not necessarily
halfway) between the point elasticities calculated at the lower and
the higher prices.
 PERFECTLY INELASTIC DEMAND
RANGES OF ELASTICITY
- ELASTICITY EQUALS 0
Inelastic Demand
Price Demand
Percentage change in price is greater than
percentage change in quantity demand.
(Absolute value of ) price elasticity of demand 1. An $5
is less than one. increase
in price... 4
Elastic Demand
Percentage change in quantity demand is
greater than percentage change in price.
(Absolute value of) price elasticity of demand
is greater than one.
100 Quantity
2. ...leaves the quantity demanded unchanged.

INELASTIC DEMAND UNIT ELASTIC DEMAND

- ELASTICITY IS LESS THAN 1 - ELASTICITY EQUALS 1
Price Price

1. A 25% $5 1. A 25% $5
increase increase
in price... 4 in price... 4

Demand Demand

90 100 Quantity 75 100 Quantity

2. ...leads to a 10% decrease in quantity. 2. ...leads to a 25% decrease in quantity.
 ELASTIC DEMAND PERFECTLY ELASTIC DEMAND
- ELASTICITY IS GREATER THAN 1 - ELASTICITY EQUALS INFINITY
Price Price
1. At any price
above $4, quantity
1. A 25% $5 demanded is zero.
increase
in price... 4 $4 Demand

Demand
2. At exactly $4,
consumers will
buy any quantity.

50 100 Quantity 3. At a price below $4, Quantity

2. ...leads to a 50% decrease in quantity. quantity demanded is infinite.

PRICE ELASTICITY OF DEMAND ELASTICITY ALONG A LINEAR DEMAND CURVE

Point elasticity of
 Therefore,
demand varies
depending on where
 The steeper the demand curve, the more Ed =  (perfectly elastic) it is measured along
$10 the demand curve.
inelastic the demand for the good becomes. 9
8 Ed > 1 (elastic)
 The flatter the demand curve, the more
7
elastic the the demand for the good becomes. 6
Price 5 Ed = 1 (unitary elastic)
 Two extreme cases of demand curves:
4
Perfectly inelastic demand – vertical 3 Ed < 1 (inelastic)
Perfectly elastic demand – horizontal 2
1 Ed = 0
0 1 2 3 4 5 6 7 8 9 10
Quantity (perfectly inelastic)
 DETERMINANTS OF
PRICE ELASTICITY OF DEMAND
 Necessities versus Luxuries
 Availability of Close Substitutes
 Definition of the Market
 Time Horizon
 Personal Income
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
 Demand tends to be more inelastic
If the good is a necessity.
If the time period is shorter.
The smaller the number of close substitutes.
The more broadly defined the market (because very
few close substitutes exist for broadly defined
market).
The higher is personal income (Perhaps the elasticity
of demand decreases with income. That is because
the wealthy have so much money that they are
relatively insensitive to price changes.).
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
Demand tends to be more elastic
 ifthe good is a luxury.
 the longer the time period (In general, consumers take time
to adjust consumption habits and more substitutes are usually
available in the long run).
 the larger the number of close substitutes.
 the more narrowly defined the market.
 This is because, in narrowly defined markets, close
substitutes are more likely to exist.
 For example, market for camel cigarettes vs. market for all
cigarettes. The demand for camel cigarettes is likely to be
relatively more elastic.
 the lower is personal income (Those in poverty have little
money and are likely to be relatively more responsive to price
changes.).
IS THE LONG RUN ELASTICITY HIGHER THAN
SHORT RUN ELASTICITY FOR ALL THE GOODS?
•No.
•Although it is true for most of the
Price DSR
goods.
•For example, gasoline demand is
relatively more elastic in the long
run. Why?
•In the long run, people tend to drive
smaller and more fuel efficient cars.
•But what about automobiles (or
durables)?
DLR
Quantity of gasoline
DEMAND ELASTICITY FOR CARS IN THE SHORT DEMAND FOR GASOLINE
RUN AND LONG RUN • When car price increases, initially, people may
put off immediate car purchase.
• In the long run, older cars must be replaced.
Price DLR • In fact, if goods are durable, then when price
increases, consumers choose to hold on to the
good instead of replacing it.
• But in the long run, older durable goods will
have to be replaced.
• So, for durable goods, demand is more elastic DEMAND FOR AUTOMOBILES
in the short run.

DSR
•Demand of durable goods fluctuate sharply due to income
change.
Quantity of cars
•That’s why, business cycle (recessions and booms) has huge
impact on demand of durable goods.

DEMAND ELASTICITY AND TOTAL

REVENUE
ELASTICITY AND TOTAL REVENUE
Elastic
$10 K Demand
 If Ed is elastic (Ed > 1), a rise in price lowers C J Ed > 1
total revenue 8
 If Ed is inelastic (Ed < 1), a rise in price
Price 6
increases total revenue A B Gained
 If Ed is unit elastic (Ed = 1), a rise in price leaves 4 revenue
total revenue unchanged. Lost
2 revenue

0
1 2 3 4 5 6 7 8 9 Quantity
 HOW TOTAL REVENUE CHANGES
ELASTICITY AND TOTAL REVENUE ALONG A LINEAR DEMAND CURVE

$10 Inelastic
Demand
Ed < 1
8 Elastic range Ed > 1

Total revenue
6 Ed = 1
Price

Gained Lost
4 revenue revenue
Inelastic range
H Ed < 1
2 G
C 0 0
Q0 Quantity Q0 Quantity
A B (a) (b)
0
1 2 3 4 5 6 7 8 9 Quantity

INCOME ELASTICITY OF DEMAND

ELASTICITY AND REVENUE  Income elasticity of demand measures how
much the quantity demanded of a good
 Fora linear dd
responds to a change in consumers’ income.
curve, P = a – bQ,
revenue will be  Itis computed as the percentage change in the
maximum when quantity demanded divided by the percentage
P = a/2 i.e., price change in income.
elasticity of
demand = -1. Elasticity of demand wrt income,

 As is the case with price elasticity, income

elasticity also changes over time (e.g., for
durable goods, short run elasticity will be
higher than the long run elasticity).
 INCOME ELASTICITY - TYPES OF GOODS INCOME ELASTICITY – SHORT-RUN VS LONG-RUN
 For non-durables
 Normal Goods
 Income elasticity is larger in the long-run
 Income Elasticity is positive.  For durables
 Necessity Goods  Income elasticity is larger in the short-run (say >2)
 Income Elasticity is positive but less than 1.  Consequently, demand fluctuates sharply due to
income change in the short-run
 Luxury or Superior Goods
 That’swhy, durable goods industries can be
 Income Elasticity is more than 1. called as cyclical industries
 Sticky Goods
 Income Elasticity is zero.
 Inferior Goods
 Income Elasticity is negative.
Higher income raises the quantity demanded for normal
goods but lowers the quantity demanded for inferior goods.

PRICE ELASTICITY OF SUPPLY

CROSS PRICE ELASTICITY OF DEMAND
 Elasticity measure that looks at the impact a
change in the price of one good has on the
demand of another good.
 Elasticity of demand of product A wrt Price of
product B,
 Positive– Goods are Substitutes
 Negative – Goods are Complements
 The price elasticity of supply measures the
relationship between change in quantity supplied
and a change in price and
 isdefined as the percentage change in quantity
supplied divided by the percentage change in
price
 In general, price elasticity of supply is higher in
the long-run for obvious reasons

 Zero – Goods are Independent

PRICE ELASTICITY OF SUPPLY PRICE ELASTICITY OF SUPPLY
When supply When supply
is perfectly is perfectly
inelastic, a elastic a firm
shift in the can supply any
demand curve amount at the
same price.
has no effect
Firm can
on the supply at a
Demand curve equilibrium constant unit
quantity cost and has
supplied no capacity
(supply of constraint. A
tickets for change in
sports demand alters
the
venues).
When supply is When supply is relatively equilibrium
quantity but
relatively inelastic a elastic a change in not the market
change in demand demand can be met clearing price.
The value of price elasticity of supply is positive, because an affects the price more without a significant
increase in price is likely to increase the quantity supplied in the than the quantity change in market price.
market. supplied.

DETERMINANTS OF THE PRICE ELASTICITY OF SUPPLY AN APPLICATION OF ELASTICITY CONCEPT:

PRICES OF BRAZILIAN COFFEE
 SPARE CAPACITY
If there is plenty of spare capacity, the firm should be able to
increase output quite quickly without a rise in costs and
therefore supply will be elastic.
 STOCKS
If stocks (or inventories) of raw materials, components and
finished products are high then supply will be elastic.
 Why are coffee prices very volatile?
 EASE OF FACTOR SUBSTITUTION
If capital and labour resources are occupationally mobile then Most of the world’s coffee is produced in Brazil
the elasticity of supply for a product is likely to be higher.
 TIME PERIOD Changing weather conditions affect the crop of coffee, thereby
Supply is likely to be more elastic, the longer the time period affecting price
a firm has to adjust its production. In the short run, the firm
may not be able to change its factor inputs. Price following bad weather conditions is usually short-lived

In long run, prices come back to original levels, all else equal
THE WEATHER IN BRAZIL AND THE PRICE OF THE WEATHER IN BRAZIL AND THE PRICE OF
COFFEE IN NEW YORK COFFEE IN NEW YORK

PRICE OF SUPPLY AND DEMAND

BRAZILIAN FOR COFFEE
COFFEE (a) A freeze or drought in
When droughts or Brazil causes the supply curve
freezes damage to shift to the left.
Brazil’s coffee trees, In the short run, supply is
the price of coffee can completely inelastic; only a
soar. fixed number of coffee beans
can be harvested.
E.g., in July 1975
(winter in southern Demand is also relatively
inelastic; consumers change
hemisphere), a frost
their habits only slowly.
destroyed 1976-77
crop. Price/pound As a result, the initial effect of
the freeze is a sharp increase in
increased from 68
price, from P0 to P1.
cents in 1975 to $2.7
in 1977.

THE WEATHER IN BRAZIL AND THE PRICE OF THE WEATHER IN BRAZIL AND THE PRICE OF
COFFEE IN NEW YORK COFFEE IN NEW YORK

SUPPLY AND DEMAND SUPPLY AND DEMAND FOR

FOR COFFEE
(b) In the intermediate
run, supply and demand
are both more elastic; thus
price falls part of the way
back, to P2.
COFFEE
(c) In the long run, supply is
extremely elastic; because new
coffee trees will have had time to
mature, the effect of the freeze
will have disappeared. Price
returns to P0.
 UNDERSTANDING AND PREDICTING THE EFFECTS OF
Understanding and Predicting the Effects of Changing
CHANGING MARKET CONDITIONS: AN EXAMPLE OF
Market Conditions: An Example of Copper Market
COPPER MARKET
Copper Prices, 1965–2007
After reaching a level of about $1.00 per pound in 1980, the
price of copper fell sharply to about 60 cents per pound in
1986.
Worldwide recessions in 1980 and 1982 contributed to the
decline of copper prices.
Why did the price increase sharply in 2005–2007?
First, the demand for copper from China and other Asian
countries began increasing dramatically.
In real terms, copper prices declined steeply from the early 1970s through the mid-
Second, because prices had dropped so much from 1996 1980s as demand fell. In 1988–1990, copper prices rose in response to supply
disruptions caused by strikes in Peru and Canada but later fell after the strikes ended.
through 2003, producers closed unprofitable mines and cut Prices declined during the 1996–2002 period but then increased sharply during 2005–
production. 2007.

QUESTION ANSWER
WHAT HAVE YOU LEARNED SO FAR WHAT HAVE YOU LEARNED SO FAR

 Suppose the market for frozen orange juice is in

equilibrium at a price of $1.00 per can and a quantity of
4200 cans per month. Now suppose that at a price of
$1.50 per can, quantity demanded falls to 3000 cans per
month and quantity supplied increases to 4500 cans per
month.
 A.
Draw the appropriate diagram, linear demand and
supply curve, for this market
 B.Calculate the price elasticity of demand for frozen
orange juice between the prices of $1.00 and $1.50. Is
the demand elasticity elastic or inelastic?
 C.Calculate the elasticity of supply for frozen orange
juice between prices of $1.00 and $1.50. Is the supply
elasticity elastic or inelastic?
 SUPPLY, DEMAND, AND GOVERNMENT
POLICIES
 Ina free, unregulated market system, market
forces establish equilibrium prices and exchange
quantities.
 One of the things government can do is to set
price controls when the market price is seen as
unfair to either buyers or sellers.
PRICE CEILINGS AND PRICE FLOORS
Price Ceiling
A legally established maximum price at which a good can
be sold. (Fee charged by private engineering colleges, say,
in UP)
 You can’t charge more than the set price.
Price Floor
A legally established minimum price at which a good can
be sold. (Price Supports for wheat, sugarcane, etc.)
 You can’t charge less than this price.

PRICE CEILINGS
A PRICE CEILING THAT IS BINDING...
Two outcomes are possible when the government
imposes a price ceiling: Price of
Ice-Cream
Cone
Supply
 The price ceiling is not binding if set above the
equilibrium price. Equilibrium
price
 The price ceiling is binding if set below the
equilibrium price, leading to a shortage. $3

 Binding means that there is an economic 2 Price

ceiling
impact.
Shortage
Demand

0 75 125 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
 EFFECTS OF PRICE CEILINGS
A PRICE CEILING THAT IS NOT BINDING...
Price of
A binding price ceiling creates ...
Ice-Cream
Cone  shortages because QD > QS.
Supply
 Example: CNG shortage in Lucknow (long queues at
filling station)
Price
$4
ceiling  non-price rationing
 Examples: Long lines, Discrimination by sellers, etc.
3

Equilibrium …some people gain (few consumers) and some

price lose (producers and ‘rationed out’ consumers)
due to binding price ceiling.
Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones

PRICE FLOORS A PRICE FLOOR THAT IS NOT BINDING...

When the government imposes a
Price of
price floor, two outcomes are Ice-Cream
Cone
possible. Supply

Equilibrium
 The price floor is not binding if set below price

the equilibrium price. $3

 The price floor is binding if set above the
Price
equilibrium price, leading to a surplus. 2
floor

Demand

0 100 Quantity of
Equilibrium Ice-Cream
quantity Cones
 A PRICE FLOOR THAT IS BINDING... EFFECTS OF A PRICE FLOOR
A binding price floor causes . . .
Price of
Ice-Cream  a surplus because QS >QD.
Cone
Supply
Surplus

$4 Price floor Examples: The minimum

$3
wage, agricultural price
supports, ….
Equilibrium
price

Demand

0 80 120 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones

THE MINIMUM WAGE

THE MINIMUM WAGE
A Labor Market with a
A Free Labor Market Minimum Wage
Wage Wage
Labor Labor
supply Labor surplus supply
(unemployment)
Minimum
wage
Equilibrium
wage

Labor Labor
demand demand
0 Equilibrium Quantity of 0 Quantity Quantity Quantity of
employment Labor demanded supplied Labor
 IMPACT OF A 50¢ TAX LEVIED ON BUYERS...
WHAT ARE SOME POTENTIAL Demand function, P = a – bQ where P = price per unit charged by
sellers and paid by buyers.
IMPACTS OF TAXES? P+0.5 = a – bQ  P = (a-0.5) – bQ, where buyers pay P+0.5 per unit,
out of which, sellers get P, and the government gets 0.5.
Price of
Taxes are used to raise money for the Ice-Cream
Supply, S1
government. Price
Cone
P=1+0.02Q
Taxes discourage market activity. buyers
pay $3.30
When a good is taxed, the quantity Price 3.00 Tax ($0.50)
Equilibrium without tax

sold is smaller. without

tax
2.80

Buyers and sellers share the tax

Price
burden. sellers
Equilibrium
with tax
But who bears the greater burden-tax receive
D1
incidence. P=6-0.03Q
D2

0 90 100 Quantity of
Ice-Cream Cones

IMPACT OF A 50¢ TAX ON SELLERS... THE INCIDENCE OF TAX

Supply function, P = a + bQ where P = price per unit received.
P-0.5 = a + bQ  P = (a+0.5) + bQ, where buyers pay P per unit, out
of which, sellers get P-0.5, and the government gets 0.5. The incidence of a tax refers to who bears the burden
Price of of a tax.
Ice-Cream
Cone A tax on sellers In what proportions is the burden of the tax
Price S2 shifts the
buyers Equilibrium
supply curve
divided?
pay with tax
$3.30 S1
upward by the How do the effects of taxes on sellers compare
amount of the
Price 3.00 Tax ($0.50) P=1+0.02Qtax ($0.50). to those levied on buyers?
without 2.80
tax Equilibrium without tax

Price
sellers
receive
The answers to these questions
Demand, D1
P=6-0.03Q
depend on the elasticity of demand
and the elasticity of supply.
0 90 100 Quantity of
Ice-Cream Cones
 ELASTIC SUPPLY, INELASTIC DEMAND... INELASTIC SUPPLY, ELASTIC DEMAND...

Price 1. When supply is more 1. When demand is more

Price elastic than supply...
elastic than demand...
Price buyers pay Supply
Price buyers pay
Supply
Price without tax 3. ...than on consumers.
Tax 2. ...the Tax
incidence of the
Price without tax tax falls more
heavily on Demand
Price sellers receive consumers... Price sellers receive 2. ...the
incidence of
the tax falls more
3. ...than on Demand heavily on producers...
producers.
0 Quantity 0 Quantity

ELASTICITY AND ITS APPLICATION:

ELASTICITY AND TAX INCIDENCE
A CASE STUDY OF THE TIMES NEWSPAPER
So, how is the burden of the tax  There are four major national newspapers in
divided? UK: The Times, Guardian, Daily Telegraph,
and Independent.
 They sell around 2.5 million copies daily.
 The burden of a tax falls more heavily on the side of  In September 1993, The Times unilaterally
the market that is less elastic.
lowered its price by one-third from 45 pence
 The incidence of a tax does not depend on whether to 30 pence.
the tax is levied on buyers or sellers.
 Initially all the major competing newspapers kept
their prices constant as if nothing had happened.
Only later did a price war break out.
A CASE STUDY OF THE TIMES NEWSPAPER A CASE STUDY OF THE TIMES NEWSPAPER
 price elasticity of demand of The Times = -
Changes in the demand for newspapers
17.5/40 = -0.44
Price Avg. daily sales Percentage  What will happen to the revenue of The Times
(in pence) change (mid- after price reduction?
Pre- Post- Pre- Post- point formula) It’ll obviously go down (inelastic demand). Daily
Sept. 93 Sept. 93 Sept. 93 Sept. 93 Price Sales sales revenue of The Times fell from £ 169,576 to £
The Times 45 30 376836 448962 -40=(30- +17.5 134,689.
45)*100/((
45+30)/2)
Remember, revenue will increase with reduction in
45 45 420154 401705 0 -4.5
price only when absolute value of price elasticity of
Guardian demand is greater than 1.
Daily 45 45 1037375 1017326 0 -1.95
 Thecompeting papers suffered, and the
Telegraph Independent suffered most (15.2% loss of
Independent 50 50 362099 311046 0 -15.2 sales).
 Independent was the closest substitute for the The
2196464 2179039
Times (cross elasticity of demand = +0.38).

A CASE STUDY OF THE TIMES NEWSPAPER

A CASE STUDY OF THE TIMES NEWSPAPER
Demand for The Times and the Independent
Applying demand and supply concepts

 Each
newspaper sells all the copies that are
demanded at the price that it sets.
So, supply curve for each newspaper is horizontal
(the elasticity of supply is effectively infinite at the
set price).

 What will be the effect of The Times’ price cut

both on The Times and on the Independent?
 Note: Since each newspaper is a distinct product,
there is no industry supply curve. Each supplier
simply sets a price and lets demand determine its Movement along the curve Shift of the curve
sales.
A CASE STUDY OF THE TIMES NEWSPAPER
 Since demand is inelastic for newspapers in the UK, it
was a good strategy for rival newspapers not to reduce
their prices.
 Although the Independent suffered a daily loss of
revenue a little over £ 25000, it would have lost more
by cutting its price.
 But, why The Times persisted with its price drop?
 Increase in advertising revenue (which depends on
circulation) could be one of the important reasons.
 Increase in daily advertising revenue should be more than
£ 35000 (which is drop in sales revenue) to make price cut
profitable.
A CASE STUDY OF THE TIMES NEWSPAPER
 Indeed, The Times did continue to increase its market
share.
 In June 1994 the Telegraph reacted to The Times’
growing market share by cutting its price, and the
Independent followed.
 The Times reduced its price further, although prices
settled down at slightly higher levels soon after.
By July 1998 The Times’ price was 35p while other three
major papers were at 45p.
By July 1998 The Times’ sales were 800,000, almost
double what was in early 1994. In contrast, the
Independent’s sales were just 210,000, less than 60%
…(long run elasticity ...)
A CASE STUDY OF THE TIMES NEWSPAPER
 Predatory pricing (charge a low price to force the rivals
out of business) could be another reason.
The Independent was indeed in financial difficulty before The
Times’ price cut announcement.
Since Independent was the closest substitute, predatory pricing
can’t be ruled out.
However, the Independent was taken over by the Mirror group,
which had more financial resources. Later it was sold to an
Irish newspaper group.
Therefore, if The Times had been following a predatory pricing
strategy, it failed.
 Another possibility – The Times’ manager might have
expected that its demand elasticity would increase over
time (that is, sales will increase at greater rate in the
long-run).
A CASE STUDY OF THE TIMES NEWSPAPER
 Market share of major newspapers was
virtually unchanged during the next 5 years.
 During mid-2002, sales of The Times were
running just over 700,000 daily, the Guardian
at just under 400,000, the Independent at about
220,000 and the Telegraph just over 1 million.
 From 2002 onwards, The Times’ has to compete
not only with other newspapers but also with
the internet and 24 hours news channels.

A CASE STUDY OF THE TIMES NEWSPAPER
 Now, strategy to gain market share may be different
than just price cut (value added services, bundling and
tying, etc.).
 However, the aggressive pricing strategy adopted by
The Times in the early 1990s does appear to have had a
very long lasting effect on the sales pattern of the UK
newspapers.
 The changes in the sales pattern established in the
mid-1990s are still evident, even though the price war
is over. (In early 2007, The Times was priced at 65p
while others at 70p.)
 Think of a network good; once you gain the market, you
can continue to be market leader (unless product
becomes obsolete).
QUESTION
 American Mining Company is interested in obtaining
quick estimates of the supply and demand curves for
coal. The firm's research department informs you that
the elasticity of supply is approximately 1.7, the
elasticity of demand is approximately -0.85, and the
current price and quantity are $41 and 1,206,
respectively. Price is measured in dollars per ton,
quantity the number of tons per week.
a. Estimate linear supply and demand curves at the
current price and quantity.
b. What impact would a 10% increase in demand have on
the equilibrium price and quantity?
c. If the government refused to let American raise the price
when demand increased in (b) above, what shortage is
created?

b.
ANSWER
Multiply demand equation by 1.10.
1.10 (2231 - 25P)
Qd' = Qs and solve
Qs = -844 + 50P
Set Qd' = Qs and solve.
THANKS
2454.1 - 27.5P = -844 + 50P
3298.1 = 77.5P
P = 42.56
Substitute P into Qd' to find quantity demanded.
Qd' = 2454.1 - 27.5(42.56)
Qd' = 1283.7 or 1284
c.
Since price cannot rise, the shortage will be the quantity
demanded with the new demand minus the quantity supplied
with the unchanged supply.
Quantity demanded: Q = 2454.1 - 27.5(41) = 1326.6
Quantity supplied: Q = -844 + 50(41) = 1206.0
Shortage = 1326.6 - 1206.0 = 120.6 tons per week.